Journal of Financial Planning: May 2015
David M. Cordell, Ph.D., CFP®, CFA, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFA, is a professor of business law at Roger Williams University in Bristol, Rhode Island.
In 2014, a mid-term election year, Congress accomplished little in the nature of tax reform with the exception of extending several expiring tax benefits through December 31, 2014. Because 2016 is a presidential and Congressional election year, any major change in tax policy in the near-term is likely to be addressed by Congress in 2015. What will the changes be?
In February, President Obama released the Administration’s Fiscal Year 2016 Green Book, detailing his budget and tax proposals for the fiscal year beginning in October 2015. Although the Green Book is the President’s wish list for budgetary and tax changes rather than a legislative proposal, it is the starting point for discussion.
The 2016 Green Book proposes several significant changes to tax policy that planners and clients have relied on for decades. Although it is unlikely that all of these provisions will be adopted into law, they may influence the direction of tax policy. Some of the proposals would have a direct impact on uses of life insurance in financial planning.
Changes Affecting Life Insurance
Life insurance is used in personal financial planning for two primary purposes: (1) to hedge against the risk of loss of human capital; and (2) to enhance wealth on a tax-free basis. As long as a client has financial goals and objectives for his or her family that are yet to be funded, use of life insurance as a hedge against the loss of the human capital will continue to be an important cornerstone of a well-constructed financial plan, and will not be significantly affected by the tax policy changes proposed in the Green Book. However, if some or all of the President’s Green Book proposals are adopted into law, the demand for life insurance to enhance the family’s wealth on a tax-free basis will likely increase.
Several individual tax change proposals in the Green Book may result in an increase in demand for the use of permanent life insurance. Among the most significant of the proposed changes to individual taxation are:
- Raising the capital gains tax rate from 23.8 percent (consisting of the 20 percent base rate plus the 3.8 percent Affordable Care Act Surtax) to 28 percent for high-income taxpayers.
- Treating gifts of appreciated property as a realization event requiring the recognition of gain and the payment of capital gains tax.
- Imposing a minimum tax of 30 percent on taxpayers with income over $1 million.
- Reducing the estate and generation skipping transfer tax exemptions from their current level of $5.43 million (indexed for inflation annually) to $3.5 million with no annual inflation indexing.
- Reducing the lifetime gift tax annual exclusion from $5.43 million to $1 million. Eliminating the I.R.C. Sec. 1014 “step-to” basis provision and replacing it with a $100,000 per person exclusion at death. Note that “steps” can be down as well as up.
Of course, permanent life insurance products, such as whole life insurance and variable universal life insurance policies, provide a savings feature and death benefit protection. The money inside the policy grows on a tax-deferred basis during the lifetime of the insured, and is paid income tax free to the named beneficiary on the policy. With increasing capital gains and ordinary income tax rates, wealthy clients may find investing inside a life insurance policy will be preferable to investing in a non-qualified investment account. While there will be additional costs in using life insurance, such as mortality and expense risk charges, those costs are offset by the higher income tax costs incurred in non-qualified accounts.
Clients wishing to shift assets to other family members could do so through a tax-free loan from a life insurance policy without triggering recognition of gain, unlike the situation that the owner of non-qualified assets will face under the President’s proposals. The President’s proposal to eliminate the step-to basis provision of I.R.C. Sec. 1014 won’t be an issue for death benefits paid on a life insurance policy, since the beneficiary receives those benefits on an income tax free basis.
Moderately wealthy clients may find the tax benefits of a life insurance policy preferable to the Green Book proposals, particularly if they want to leave more than $100,000 without transferring the gain on non-qualified property and the commensurate capital gains tax liability to their heirs. Of course, clients could use life insurance, owned by a trust, to leave more than $3.5 million to their heirs without triggering an estate tax liability.
Impact on Retirement Planning
Several Green Book proposals to change the rules regarding retirement planning could increase the demand for life insurance products as an alternative planning strategy for both individuals and businesses. The most significant retirement planning changes include:
- Eliminating “stretch” IRAs by requiring non-spouses to distribute inherited IRA funds within five years.
- Depriving individuals with more than a specified amount in their retirement accounts from making contributions to retirement accounts (currently projected to be $3.4 million for a 62-year-old, but the amount will vary annually with interest rates, mortality estimates, and participant age).
- Repealing the special exclusion for net unrealized appreciation (NUA) for lump sum distributions of employer securities from employer plans.
- Requiring plans to expand eligibility requirements to include part-time employees who worked at least 500 hours per year in three consecutive years.
- Limiting Roth conversions to pre-tax dollars.
Many of the Green Book retirement planning proposals are aimed at limiting taxpayer use of tax-advantaged qualified retirement plans and IRAs. Studies indicate that Americans have a significant portion of their financial worth invested in their homes and retirement plans, so not surprisingly many Americans view their retirement savings as an attractive asset to satisfy their bequest objectives. If all inherited retirement assets (except for those passing to a surviving spouse) must be distributed within five years of the participant’s death, significant tax liability will be incurred by the recipients, potentially forcing them into higher tax brackets and reducing the wealth transfer for the heirs.
An alternative to using pension plans for legacy planning in the face of a five-year required distribution of taxable income is using a permanent life insurance policy. Like a pension plan or IRA, the life insurance policy will accumulate funds on a tax-deferred basis, but unlike the retirement account the death benefit will not be subject to income tax and may be structured to provide benefits for the recipient over a period exceeding five years. Furthermore, during the lifetime of the insured, the insured could access the funds through policy loans on an income tax free basis.
Individuals affected by the proposal to cap retirement plan contributions could also consider using permanent life insurance as an alternative to the qualified plan for the same reasons described above. This proposal is particularly troublesome because many individuals who have contributed to retirement plans throughout their lifetime and hit the proposed retirement savings cap will lose the ability to make future contributions and lose matching contributions provided by an employer. It’s unlikely that employers will match contributions made to life insurance policies as a substitute for retirement contributions.
Life insurance policies are similar to Roth retirement accounts inasmuch as they provide tax-free growth to their owners. Individuals unable to make pre-tax contributions to retirement accounts due to income limitations may wish to consider making those contributions to a life insurance policy instead of an IRA. Under the Green Book proposals, after-tax contributions to an IRA couldn’t be converted to a Roth IRA, eliminating the opportunity to shelter internal account growth from eventual income taxation. If those contributions are made to a life insurance policy instead of an IRA, the growth is tax deferred, cash values can be accessed tax free through policy loans, and the death benefit is exempt from income tax. All of these features are similar to the benefits of using a Roth IRA, or completing a Roth conversion.
A Business Advantage
Businesses may find that the repeal of special tax features associated with qualified plans, such as the NUA tax treatment referenced above, combined with expanded eligibility for employee participation in qualified plans may make using qualified plans less attractive to the business and its owners. Using non-qualified plans, which are often funded with life insurance, permits business owners to mimic many of the benefits associated with qualified plans without incurring the time and expense associated with establishing and maintaining qualified plans. Taking too many tax benefits away from retirement planning may, indeed, create an increased demand for permanent life insurance as a funding vehicle for non-qualified plans established by businesses.
The uses of life insurance described here were employed by financial planners in earlier years when tax rates were higher and retirement planning options were fewer. Perhaps if Congress adopts the President’s proposals, clients and planners will have to adjust their strategies back to the future.